Inside Facebook: What SEC documents reveal about the social-networking monolith

Facebook filing for an initial public stock offering isn’t exactly a surprise, but it does provide a first-ever opportunity to look inside some of Facebook’s business fundamentals. Guess what? Some of those business fundamentals aren’t exactly what potential investors and the general public expected — and a few point to the ways Facebook will have to behave in the future to keep its new investors happy.

What could that mean for Facebook users? For starters, expect Facebook to build on its already-aggressive targeted marketing. That means more — and increasingly personalized — ads throughout the entire Facebook experience. Second, Facebook may have to start looking at ways to start earning more money from users directly, perhaps through new partnerships with app and game developers, or perhaps by charging users directly for premium services. Third, Facebook users should prepare for Facebook to start providing opportunities for people to let it pry into even more corners of their lives.

Follow the money

For years, Facebook founder Mark Zuckerberg claimed going public wasn’t on his agenda: Facebook was happy to be a private company that could make its own deals, live its own “hacker culture,” and innovate quickly, rather than having to deal with the headaches of being a publicly traded stock and having to respond to every whim, rumor, earthquake, or imaginary shadow that might cross the public markets. However, Facebook’s hand on the IPO was forced by federal regulations: The company already has more than 500 individual shareholders, meaning it would either have to go public or begin providing much more detailed reporting to the SEC on its inner workings. Either way, the veil on many of Facebook’s inner workings was going to drop, and Facebook decided to go with the way that would likely bring it a ton of spending cash.

As a result, Facebook’s 197-page filing with the Securities and Exchange Commission contains a wealth of information about how Facebook runs its business, while still keeping some important information in confidence. For starters, the filing confirms that Facebook is rolling in cash, raking in some $3.7 billion in revenue last year and producing $668 million in net profit off that income. Back in 2009, Facebook managed to keep $122 million on $777 million in revenue. That means Facebook is currently keeping nearly one of every five dollars it brings in (put another way, spending four of every five it’s paid). That proportion has improved a bit as the company has experienced massive growth: Facebook keeps a bit more of the money it pulls in today than it did in 2009, when the company’s earnings were about 15 percent of revenue.

The SEC filing also reveals where Facebook earns that money. Some 44 percent of Facebook’s revenue last year (or about $1.63 billion) came from outside the United States; further, some 85 percent of Facebook’s revenue — about $3.14 billion — came from advertising. Most of the remainder came from the 30 percent cut of sales it takes from apps and games using the Facebook platform.

Facebook says it ended 2011 with 845 million users, which puts the company on track to crack the 1 billion user threshold by mid-2012. Back-of-the-envelope math reveals that Facebook’s revenues translated to about $4.38 per user in 2011. To some industry watchers, that’s a bit of a disappointment, since it compares unfavorably with other major Internet companies. For instance, Amazon generated an estimated $189 per user per year in 2011 — although, of course, Amazon is in the business of selling things. Online auction giant eBay generated some $39 per user in 2011. And Google — which, like Facebook, is primarily in the business of offering free services and generating revenue via advertising — produced an estimated $24 per user in 2011.

Another interesting revelation: Facebook says some 425 million of its monthly active users (that’s more than half its total user base) used Facebook mobile products in December 2011. That means about half of Facebook’s users got an ad-free experience, which in turn decreased Facebook’s revenue per user.

Cash cow

So, with all that revenue and favorable earnings, why is Facebook interested in an IPO? Facebook doesn’t make and sell physical products, so it avoids the supply chain, retailing, warehousing, and similar logistic concerns faced by companies like Apple, Samsung, HP, Amazon, and others. However, the company does have significant costs both in terms of human resources (hiring the best and brightest isn’t cheap) and the complex data centers that are the heart of its operations. All these things take money. While Facebook has a strong revenue stream, the SEC filing reveals that the company’s cash horde only amounts to about $3.9 billion. To be sure: $3.9 billion is a lot of money, but it’s utterly dwarfed by companies like Google and Apple, which have in the neighborhood of $45 billion and $100 billion in the bank.

So, the motive behind Facebook’s decision to go with an IPO — rather than merely complying with increasing filing regulations — becomes clear: It’s all about cash. Although the filing doesn’t reveal how many shares Facebook plans to offer to the public or what their eventual pricing might be (it’s still too early in the process for those things to be set), the company looks like it wants to raise about $5 billion in cash, more than doubling the amount of spending money the company has onhand.

Why would Facebook need spending money? One expense is infrastructure. Facebook has been sinking funds into its own custom data centers: the first was in in Prineville, Oregon, and a new facility is going up in North Carolina. Facebook has never said how much these cost, but it’s safe to bet that the two custom data centers clock in at half a billion dollars or more. (Disclosure: a long-time acquaintance is the lead tech at Facebook’s Prineville facility.) Facebook also has leased data center facilities in Virginia and California; Facebook says it thinks these existing data facilities will tide it over for the time being, but if Facebook continues to experience phenomenal growth (particularly in international markets) it will likely have to invest in additional infrastructure.

Cash will also fuel acquisitions. Facebook’s IPO filing reveals the company spent $68 million last year acquiring other companies: Snaptu, DropIO, Beluga, Nextstop, and Push Pop Press all spring to mind. However, while the details are a bit thin, one pattern does emerge: Facebook has increasingly been acquiring other companies through offerings of Class A stock, where early buys (like Parakey, Facebook’s first acquisition) were granted Class B stock. Class A stock has one tenth the voting power of Class B shares, so folks brought on board recently with Class A stock have less influence on the company. Raising an additional $5 billion in cash will not only enable Facebook to begin to focus on making larger deals (rather than acquiring startups with a handful to a few dozen employees), but will also enable the company to sidestep much of the issue of offering stock to potential acquisitions. Cash talks.

The same thing goes for employees. When Facebook goes public, many of the company’s early employees and top players will find themselves transitioned into millionaires overnight. (Zuckerberg himself is expected to buy 120 million shares of Facebook stock and voluntarily reduce his own salary to $1 a year.) However, once the company is public, it will be more difficult for Facebook to bring key employees on board with promises of stock options. Until now, Facebook has been able to lure key employees with stock-option grants that would likely be very profitable when the company went public, but that windfall is only going to happen once. Although Facebook will continue to incentivize and retain key employees through stock grants and scheduled vesting, it will no longer be able to attract people by the promise of a sudden payday. Instead, it will have to pay cash.

Gaming the system

One particularly curious thing Facebook revealed in its SEC filing: social gaming company Zynga accounted for a whopping 12 percent of Facebook’s total revenue in 2011 — and that’s an increase from 10 percent in 2009 and 2010. The money Facebook earns from Zynga is a mixture of the 30 percent cut Facebook takes of every Zynga transaction as well as Zynga’s own advertising buys on Facebook.

No other Facebook company accounts for more than 10 percent of Facebook’s revenue, and the distinction potentially puts Zynga in a powerful position: If Zynga were to withdraw or scale back from the Facebook platform, it could significantly impact Facebook’s revenue. That, in turn, could anger investors. Although Zynga operates many popular Facebook games, the company has endured consistently bad press for outright copying games from smaller developers. The latest accusations come from tiny game developer NimbleBit, whose Tiny Tower was Apple’s iPhone Game of the Year. Mud on Zynga’s face also sullies Facebook… and Facebook has locked Zynga into the 30 percent deal through 2015. With Zynga out of the equation, Facebook only generated $3.85 percent per user during 2011. That figure doesn’t factor in the network effect of Zynga’s games driving users to the Facebook platform, so in an imaginary world where Zynga didn’t exist, Facebook’s revenue per user would be even lower than that.

What to expect

So what will Facebook’s IPO mean for everyday users?

Expect more ads. Throughout 2011, Facebook was already been increasing the number of ads that appear on many Facebook pages in an effort to generate more advertising revenue. Expect this trend to continue in 2012 and accelerate after an IPO as Facebook faces increased pressure to earn more money for every user. This will probably mean Facebook will start bringing ads to its currently ad-free mobile apps.

Expect more opportunities to spend. Facebook is almost certainly going to ramp up its efforts to get users to buy (and spend!) Facebook credits as well as actual money through the service. Facebook will continue to work with game developers and content providers to provide paid services through Facebook, claiming 30 percent of every transaction. After all, Facebook would love to reduce its dependence on Zynga and further diversify the revenue generated through the Facebook platform. Facebook may also choose to cut out the middle man and begin offering premium services to those who wish to pay for them. These might include new account paid types for corporations, public figures, and celebrities (augmenting existing “fan pages”); Facebook might also start rolling out more cloud-based services to compete with the likes of Google and Apple’s iCloud. Another good bet here would be Facebook leveraging its 425 million mobile users and getting into the mobile payment arena: Imagine getting discounts at retailers for paying in Facebook credits using your phone.

Expect more opportunities to disclose information about yourself. Facebook’s efforts to increase advertising revenues won’t be solely based on putting more ads on pages: The company realizes if pages become too ad-laden, they will turn people off. Facebook will also be focused on charging advertisers a premium to reach Facebook users, and Facebook will justify that premium by offering advertisers ever-more-precise demographic targeting, zeroing in on traits like users’ age, gender, and location, but also their expressed interests as well as the interests of friends in their social networks. To pull that off, Facebook will continue to deploy new features (like Timeline) that encourage users to fill in ever more information about themselves that Facebook can analyze and use to target advertisements. But this is a tricky path for Facebook: it’s already subject to a 20-year agreement with the FTC that requires bi-annual reviews of its privacy practices, and proposed regulations in the EU (including a “right to be forgotten”) could significantly limit Facebook’s ability to leverage user information on behalf of advertisers.

Expect Facebook to slow down. Right now, Facebook CEO Mark Zuckerberg’s primary responsibility is growing Facebook’s business and reach. As soon as Facebook goes public, his responsibility will change to maximizing value for shareholders. That’s a very different job, and while Zuckerberg has established a solid grasp of what many social-networking users want, it’s not clear he’s the right person to lead a large, publicly traded company. At the very least, Zuckerberg’s attention will be divided between the interests of investors and the interests of Facebook’s users — which means the rapid pace of change and evolution that’s characterized Facebook’s recent years is likely to slow down. Facebook might also find itself in a situation like Yahoo and Google before it, where the whiz-kid founder(s) cede the CEO position to someone with broader industry and business experience. That might enable Facebook to continue evolving along the lines of Zuckerberg’s vision for some time… but it could also accelerate the pace at which Facebook becomes just another boring company.